Describes the preliminary findings of IMF staff at the conclusion of
certain missions (official staff visits, in most cases to member countries). Missions are
undertaken as part of regular (usually annual) consultations under
Article IV of the IMF's Articles
of Agreement, in the context of a request to use IMF resources (borrow from
the IMF), as part of discussions of staff monitored programs, and as part of
other staff reviews of economic developments.

INTERNATIONAL MONETARY FUND

Kingdom of the Netherlands-The Netherlands

2004 Article IV Consultation

Preliminary Conclusions

June 7, 2004

1. The Netherlands enjoyed considerable success in the 1980s and 1990s. As a result of tight control over public expenditure, it was possible both to cut taxes and turn large fiscal deficits into surpluses by the end of the period. Labor market reforms raised incentives to work while cuts in taxes and social security contributions supported wage moderation, boosting competitiveness and sharply reducing unemployment as the economy grew. Reforms in financial and other product markets reinforced these positive outcomes. However, while wealth effects-related to rising equity and housing prices-added further impetus to economic growth in the late 1990s, the associated economic boom was accompanied by a build-up of economic imbalances, including a significant increase in household debt.

2. Year-average growth has steadily declined since 2000-turning negative in 2003 for the first time in 20 years. A number of factors were at play, including the unwinding of imbalances associated with the boom of the late 1990s and a deterioration in the external environment. In this connection, investment has declined significantly as the rapid investment growth of the late 1990s was based on what now appears to have been unrealistic expectations of future economic growth. The collapse of equity prices weakened corporate balance sheets, another factor dampening investment. Meanwhile, export growth fell off sharply as the impact of weak external demand was accentuated by the appreciation of the euro and especially the lagged effects of the rapid growth in wage costs as a consequence of the tight labor market during the boom years. As wage growth moderated and social security contributions were increased, private consumption growth also fell and became negative in 2003. At the same time, the household saving rate rose significantly, likely reflecting a combination of factors: the fall in equity prices and the end of rapid housing price increases in a context of high household debt, and uncertainties over pensions, future reforms, and employment prospects. Indeed, the unemployment rate has risen to 6.6 percent from a trough of 3.2 percent in mid-2001.

3. The sheer magnitude of the recent fiscal deterioration is striking. Between 2000 and 2003, the general government balance deteriorated by almost 5½ percentage points of GDP as a result of both cyclical and structural effects. Structural effects-amounting to roughly 2 percentage points of GDP-included the 2001 tax reform. Perhaps more importantly, although the spending ceilings were met through 2002, temporary expenditure windfalls were used to fund permanent increases in other spending-notably on health care and education. As a result, the ceiling ratcheted up in the new coalition agreement in 2003 (and was exceeded by a small margin). Moreover, after years of running close to balance, the local governments surprisingly recorded a deficit of 0.6 percent of GDP in 2003, contributing to the breach of the 3 percent Maastricht ceiling.

4. Fortunately, the long-awaited recovery now seems in train-but with slow growth expected through the current year and downside risks a concern. The mission projects growth of about 1 percent in 2004 and about 1¾ percent in 2005. Improving exports, which should be supported by wage moderation, are the main driver-contributing to a pickup in investment in 2005 after the overhang from earlier years slows investment growth during the rest of 2004. Private consumption is expected to take longer to recover. While risks to the cyclical outlook remain tilted to the downside in the euro area, downside risks from domestic sources may be even more pronounced. In particular, high household debt accentuates that sector's exposure to income and interest rate risk. For example, although there are mitigating factors such as the dominance of fixed interest mortgages and the generally limited housing supply, a combination of faster-than-expected increases in interest rates and unemployment could still trigger a drop in housing prices. More generally, even modest changes to the wage and employment outlook could prompt a reassessment of income and therefore consumption plans. However, with a sizable output gap and little pressure from wages, inflation is expected to be tame.

5. The key challenges are to nurture the emerging recovery and improve prospects for long-term growth and fiscal sustainability in the face of an aging population. In the near term, it will be important to strike the right balance between needed fiscal adjustment and avoiding disruptions to the recovery. Thus, fiscal policy needs to be well anchored in a convincing medium-term framework to bolster confidence, but the required adjustment should not be overdone in light of near-term fragilities. In the mission's view, underlying (structural) fiscal adjustment in the range of ½ to ¾ percentage point of GDP (while letting the automatic stabilizers play) would seem to strike the right near-term balance. Various structural reforms, discussed below, are key to boosting longer-term economic prospects by raising both the labor participation rate and productivity. Implemented decisively, such reforms would be mutually reinforcing in creating employment, enhancing economic growth, and achieving fiscal saving to ensure adequate resources for an aging population.

Fiscal Policy

6. Fiscal policy is getting back on track. The mission is confident that the authorities will make every effort to ensure that the fiscal deficit is brought under 3 percent of GDP in 2004 and now estimates that the deficit will narrow in underlying structural terms by an amount in line with the range recommended above. However, as noted last year, the large rises in health care spending amid a shift to a more demand-driven system raise budgetary concerns. Thus, the suggestion in last year's coalition agreement that the reimposition of budgetary controls would be considered if necessary seems well placed, as do recent measures to contain costs (for instance, benchmarking and higher co-payments). Risks also stem from the budget situation of local governments. In these circumstances, the closer coordination between the central and local governments is helpful.

7. Policy actions to prepare for the budgetary costs of aging are becoming increasingly important. The authorities articulated in 2000 a strategy of swift debt reduction, with a view to covering the cost of aging by saving on interest payments, thus avoiding the need for tax increases. Consistent with this strategy, a target was set for the medium-term budget surplus of 1¼ -1¾ percent of GDP. While the mission continues to support the broad outlines of the strategy, the fiscal slippage over the last few years and the upward revision to future health care costs underline the need for continued fiscal adjustment in the medium term if the long-term sustainability of the public finances is to be ensured. In the mission's view, it would therefore be appropriate to aim for underlying fiscal adjustment of at least ½ percentage point of GDP per year during (and for some time after) the remainder of this government's term. Many of the structural reform measures described later would help to contain aging costs. While wide-ranging health sector reforms, to be introduced in 2006, carry the prospect of greater choice and efficiency in meeting the needs of patients, cost control may continue to be a budgetary issue.

8. The way the multi-year expenditure framework operates is key to delivering medium-term fiscal adjustment. Thus, recent efforts to strengthen the framework are commendable. On the revenue side, the mission welcomes the authorities' decision to devote revenue windfalls solely to debt reduction, thus avoiding a pro-cyclical bias. On the expenditure side, while temporary cyclical expenditure windfalls will not necessarily be used to fund spending on other items, the mission would prefer a stronger rule that precludes new spending. Also, with a view to reinforcing fiscal discipline, the principle of not allowing compensation across the spending subceilings should be pursued more consistently. While this is the government's intention, the approach in practice has been to allow below-ceiling expenditure in one category to fund increased spending in another. Finally, enhancing the transparency of the ceilings would facilitate their accessibility to a broader audience, adding an additional element of clarity and discipline to the system. In this regard, the mission sees merit in aligning the spending ceilings more closely with national accounts concepts, and focusing the ceilings solely on spending by discontinuing the practice of treating non-tax revenues as negative expenditures. More transparent and accessible ceilings would also help in communicating policy, with the potential advantage of enhancing confidence. For example, while a string of deficit-reducing spending measures can be misinterpreted as an over tightening of policy, the interpretation would more likely be in line with policy intentions when seen as bringing spending back within rising expenditure under the pre-set ceilings.

Structural Reforms

9. There is widespread agreement on the need to raise labor force participation. By bringing inactive workers back into employment, the Netherlands could ease pressures on potential growth and the public finances from an aging population. Without significant action to reduce inactivity, the kind of support that society would like to provide to an aging population may simply not be possible without unduly burdening future generations with higher taxes or increasing debt. Policies related to disability and sickness benefits, early retirement, unemployment benefits, and inactivity traps are particularly relevant. To avoid the risk of shifts from one category of inactivity to another, reforms in most of these areas must be undertaken in a comprehensive way, including with respect to the administration of benefits systems. In regard to the latter, the reported success of the recent decentralization of the provision of welfare benefits is encouraging and provides an illustration of the potential gains from setting the right incentives.

10. Disability is an area where substantial inroads could be made. With disability schemes harboring close to one million beneficiaries, equivalent to about 13 percent of employment, the number of participants is excessive. While reforms over the last few years appear to have contributed to the recent decline in new applicants, plans looking forward are appropriately much more ambitious and need to be implemented. Restricting access just to the fully disabled, and using stricter criteria and examinations, should reduce inflows. For the partially disabled, incentives to make work pay should improve the prospect of reintegrating them into the workforce. The possible increase in replacement rates for fully disabled and the abolition of experience rating (PEMBA), however, carry the risk of undercutting needed progress in reducing the number of beneficiaries. Therefore, the autumn 2003 agreement between the government and the social partners to consider implementing these measures only once the target of annual inflows below 25 thousand is reached, and only as long as social partners abstain from topping up sickness benefits, makes good sense. While durably reducing new inflows is essential, the existing stock of disability recipients also needs to be addressed and it makes sense to reassess existing cases on the basis of the new criteria.

11. The low labor force participation of older workers is another area where progress could be made. In this regard, the envisaged removal of fiscal incentives for early retirement is a positive step. Ending the mandatory nature of collective prepension schemes will foster intergenerational and actuarial fairness. In addition, the authorities have announced that they will no longer extend certain elements of collective wage contracts to unorganized firms, notably the maintenance of prepension schemes. This should provide further impetus to scaling back early retirement. More broadly, changes in life expectancy should be taken into account in determining the retirement age.

12. Reducing the generosity of unemployment benefits would also improve work incentives. The abolition of follow-up unemployment benefits works in that direction (and puts an end to using this channel to effectively retire at 57½ years of age), as would the elimination of short-term benefits. In addition, reduced generosity would lower the risk that a tightening of other social security arrangements would result in a rise in applications for unemployment benefits. In this context, further reform-especially with respect to the duration of regular unemployment benefits-would be beneficial. Following through with plans to tighten eligibility requirements is also important.

13. High replacement rates and means-tested benefits imply significant inactivity traps at the lower end of the wage scale. While the policy of gradually increasing the earned-income tax credit over time is helpful, further measures, notably on rent subsidies, are called for to make work pay. Consideration could also be given to the potential benefits of adjusting the minimum wage, as it forms the basis for determining the level of several social benefits and directly limits labor demand at lower skill levels. Carefully designed measures in line with the suggestions above would help to lower inactivity traps and stimulate not only labor supply but also the demand for low-skilled labor. These measures would seem particularly relevant in the context of an aging population and the likely associated increase in demand for personal services.

14. In addition to boosting participation, raising the economy's potential will require an acceleration of productivity growth. While the overall level of productivity is comparatively high, its growth rate has slowed considerably in recent years. The government has embraced the challenge of boosting productivity growth and established the high-level "Innovation Platform." An important item on the agenda should be the removal of obstacles to a quicker reallocation of resources into innovating sectors. The stepped-up efforts to reduce the administrative burden are clearly welcome (also in helping develop a personal services sector). Specific focus should also be put on labor markets where liberalization efforts have in general lagged behind product market reform. Employment protection is still at a comparatively high level, hinders flexibility, and serves as an implicit tax on new hiring. Greater wage differentiation would, among other things, open a channel to realizing returns from investment in human capital-a relevant complement to the government's attempts to raise the importance of private financing of higher education. It would also be helpful in attracting labor to higher productivity companies and sectors.

15. Notwithstanding recent progress, the economy would benefit from further improvements in the functioning of product markets. The Netherlands has been at the forefront of product market reforms in Europe, including the comprehensive opening of most network sectors. Nevertheless, some sectors, for example construction and nontraded services, have remained protected and it comes as no surprise that their productivity record has been particularly weak. The competition agency (NMa) has quickly established its credibility and its recent enforcement efforts are welcome. To further improve NMa's effectiveness, its powers to investigate, impose penalties, and broaden enforcement to individuals within companies rather than just the companies themselves, should be strengthened. Regulators should also persevere with efforts to open new avenues for competition in markets with strong existing incumbents. Examples include the approval of new electricity generation facilities and international transmission lines, and efforts to unbundle network transmission and production. The mission also welcomes the improved corporate governance framework in the Tabaksblat code.

The Financial Sector

16. Overall, the financial system is sound, resilient to potential adverse shocks, and well supervised.In particular, the recent Financial Sector Assessment Program (FSAP) found that the banking sector is well capitalized and diversified, with asset quality and profitability holding up relatively well in the recent slowdown. Potential risks for the financial system resulting from high debt levels (especially of households), or if the international environment were to deteriorate significantly, appear moderate and comfortably within the capacity of the banks to manage them. Insurance companies and especially pension funds, meanwhile, have been through a difficult environment in recent years, and remain exposed to any significant fall of equity prices. They have remained fairly liquid throughout, however, and are now in a rebuilding phase, underpinned by firm supervisory action.

17. Two key features of the Dutch financial system are particularly relevant for pending financial legislation. First is the local systemic importance of a few very large, sectorally integrated institutions; and second, the substantial international character of their activities, which places an added premium on supervisory coordination within Europe and more broadly. With these features in mind, the FSAP welcomes the planned new financial supervision legislation, which will both further strengthen the domestic supervisory regime in several respects, and formalize the well-designed organizational restructuring of supervision on a sectorally-integrated basis. In those few areas where autonomy is not fully delegated to the supervisors, the new legislation should spell out clearly the role of the Minister or Ministry of Finance, as applicable.

18. Beyond the new legislation, the FSAP makes a number of recommendations to help preserve longer-term financial stability. Most importantly, these include: ensuring that the Authority for Financial Markets has the power to cooperate with securities supervisors internationally even when there is no "domestic interest"; continuing to work with cross-border counterparts to further improve securities settlement arrangements; ensuring that the new pensions supervisory arrangements allow sufficient flexibility in the specified timeframe for making up shortfalls in the coverage ratio, without allowing unduly prolonged adjustment; continuing the development of the framework for dealing with crisis situations, both through further work with other supervisors internationally, and through completing the review of the domestic deposit guarantee scheme; continuing the development of macro prudential surveillance to help strengthen the early identification of risks and vulnerabilities; and, over the medium term, phasing out tax deductibility of mortgage interest, preferably in a gradual fashion to avoid disruptive effects.

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The mission would like to thank the authorities, and other participants at its meetings, for the open and stimulating discussions. The overall hospitality extended to the mission is also appreciated.